How digital finance will transform lives in India

India’s banking sector is on the cusp of change. With the Reserve Bank of India’s (RBI) recent licensing of 11 Payments Banks, the sector is poised for much-needed disruption that will bring millions of Indian households into the formal financial system for the first time.

The World Bank (2014) estimates that 47% of Indian adults are cut off from the formal financial system. This forces poor households to live their financial lives in the physical cash economy, which is both precarious and expensive. Imagine being able to save only in cash, jewelry, or livestock. Imagine having no option but to turn to a local moneylender in an emergency, or having to rely on informal couriers to send money to your family. Imagine having to go through a local official every time you want to access your social welfare transfer or pension payment. The cost and stress of conducting even simple financial transactions would be stifling.

The Prime Minister’s Jan Dhan Yojana financial inclusion program is closing this gap by encouraging banks to open accounts in poor and rural communities. Since August 2014, banks have opened 177 million accounts under PMJDY, making it the largest account opening drive in history. However, as with India’s previous mass account opening drives, banks are more focused on opening accounts than building a strong network of last-mile banking agents to service those accounts. A recent MicroSave (2015) survey of 2,682 banking agents found that India’s agents were the least trained and least profitable among the six countries surveyed. This is where Payments Banks are a game changer.

While banks have struggled globally to reach the poor, retail chains and mobile operators have built distribution networks in poor and rural communities. The RBI’s Payments Bank regulations marshal the assets of these players in service of the poor by creating a class of banks which can offer deposit accounts and payments services, but not loans. Of course, the RBI must still mitigate the operational and consumer protection risks associated with Payments Banks, but full-fledged banking regulations isn’t required when loans aren’t involved.  And once Payments Banks have established payment connections with poor customers, they will become a pipe through which credit issuing banks and insurance companies deliver credit, insurance, and other critical financial products.

These digital payment connections will improve lives. Once linked to India’s digital financial system, farmers can save their harvest proceeds in secure, interest-bearing accounts, making it more likely they have enough left to buy seeds when planting season comes around. Migrant labourers can send money to their wife and children with the click of a button. Governments can deliver social welfare payments directly into citizens’ accounts, rather than channeling them through a web of intermediaries. Over time, these transactions will leave a digital footprint that will function as a financial history, which can help the poor qualify for affordable loans.

To realize this vision, Payments Banks have to overcome two key challenges. First, international experience makes clear that Payments Banks will need to invest considerably to build and train agent networks in rural communities and be ready to wait for three to five years for the business to be cash-flow positive. This is not a game for short-term investors. Second, payment services alone will not be enough to drive customers into digital accounts. Since the RBI wisely prevents Payments Banks from offering credit and insurance on their own, Payments Banks will have to broker partnerships with credit-issuing banks and insurance companies to deliver a more complete bouquet of products.

India has a long-history of financial inclusion efforts, many of which fizzled out. But this time is different. This time, political will and an elegant regulatory model will combine to yield big gains in financial inclusion in the coming years.